Investing for the long run is easier if you temper your emotions with the knowledge that lower stock and bond prices today suggest higher future returns (and vice versa). Morningstar has just released the 2022 edition of their research paper The State of Retirement Income (e-mail required, intro article), where they point out this silver lining:

Because equity valuations have declined and cash and bond yields have increased, the forward-looking prospects for portfolios—and in turn the amounts that new retirees can safely withdraw from those portfolios over a 30-year horizon—have enjoyed a nice lift since we explored the topic last year.

Whereas last year’s research suggested that a 3.3% withdrawal rate was a safe starting point for new retirees with balanced portfolios over a 30-year horizon, this year’s research points to 3.8% as a safe starting withdrawal percentage, with annual inflation adjustments to those withdrawals thereafter.

I haven’t processed the entire 29-page paper yet, but here’s a chart summarizing the differences between the future outlooks in 2021 and 2022. Quite a difference in only a year.

None of these numbers are guaranteed of course (in fact they are virtually guaranteed to be wrong), but step back and look and the big picture. Lower P/E ratios and a higher starting interest rate definitely provide a stronger investing base. You are buying businesses at a lower price and your bonds can again provide cushion now that interest rates have room to fall. As long as you are a buyer, this is a good thing.

This is inadvertently turning into a multi-part series, mostly revolving about taking advantage of long-term TIPS to build guaranteed inflation-adjusted income. Are the current real TIPS yields worthy of locking in? The previous parts:

• 4% Guaranteed Withdrawal Rate (Inflation-Adjusted) with TIPS Ladder
• Historical Inflation Chart: 10-Year Rolling Average 1872-2022
• Sustainable Portfolio Withdrawal Rates During High-Inflation Periods

Following up on the Gerstein article from that last post, a final chart that was interesting compared the cumulative income from a low start that adjusts with inflation and a higher start that stays fixed. Starting with a $1 million portfolio, consider two simple theoretical scenarios. First, a 4% initial withdrawal rate ($40,000 in Year 1) that adjusts upward to keep up with 4% steady annual inflation. Second, a fixed annuity-style payment of $70,000 a year. Here’s how that plays out:

In such a scenario, their chart shows that the total cumulative income paid out would even out around year 27.

I was happy to see that William Bernstein – highly respected in index investing circles but relatively spare with words these days – wrote a new article Playing Inflation Russian Roulette in Retirement with a lot of good nuggets. He compares the retirement income from a single-premium immediate annuity and a 30-year TIPS ladder.

The comparison gets a bit complicated (see article to fully explain chart below), but I did take away the idea that even if you start with $70,000 annuity income like in the above scenario, you only spend $40,000 and put excess ($30,000 in year 1) rest aside in a “for future inflation” side account. You can still increase your $40,000 a year of spending annually, but keep putting the difference into the excess side account. This excess amount will decrease over time until the inflation-adjusted spending reaches and surpasses $70,000 a year, at which time you start withdrawing from the excess side account. In addition, we should consider the money left over in case of early death.

In the end, Bernstein seems to lean towards the TIPS ladder as he points out the danger of high inflation. He reminds us that “worst-case historically” doesn’t actually mean “worst-case”. How many times recently have we read the words “biggest [something] ever”?

One is reminded of Nassim Taleb’s dictum that “this so-called worst-case event, when it happened, exceeded the worst case at the time.” In other words, 5.4% long-term inflation is nowhere near the worst-case scenario. Even a casual glance at the global history of fiat money in the twentieth century shows that hyperinflation is the rule, not the exception. During the above-mentioned 1966-1995 period, U.S. debt/GDP averaged around 50%; now, it’s more twice that level and rising rapidly, and given the hundreds of trillions of dollars of additional implicit debt (promises to Social Security and Medicare, and to backstop future emergencies – think military aid to Ukraine and weather or terrorism disaster relief) it won’t take much to tip things over into a debt spiral, especially if the Treasury has to roll its debt over at higher interest rates for very long.

He also reminds us that we don’t have to do either one – the easiest way for most of us to access additional inflation-adjusted income is to delay taking Social Security:

It would be nice if one could purchase inflation-adjusted annuities, but those products have gone the way of disco, and I suspect that proposing their revival would not be a career enhancing move for any insurance company executive who suggests it. The best that one can do in this regard is to “purchase” the inflation-adjusted annuity offered by spending down one’s retirement assets to defer Social Security until age 70.

Finally, I wanted to include his relatively-conservative views on safe withdrawal rates:

The single most important factor that determines how to do that is the nest-egg burn rate (your annual spending divided by the size of your retirement portfolio). I suggest the following rule of thumb: if your burn rate is below 2% at age 60, below 3% at age 70, or below 4% at age 80, a standard stock/bond portfolio will nicely see you through your retirement, and you have no need to annuitize your assets.

I plan to keep an eye on real TIPS yields, and may readjust within the bond portion of my portfolio to purchase individual TIPS at longer maturities.

As a follow-up to my previous post on historical inflation (10-year rolling averages), how do periods of high inflation affect safe withdrawal rates for retirement portfolios? I reference a paper about Sustainable Portfolio Withdrawal Rates During High-Inflation Periods by Gerstein Fisher research, but in the middle of writing this post the source document and the entire GersteinFisher.com domain went down. (Update: Here it is on the Wayback Machine. Thanks to reader Peter for the link.)

Planning for the future with 50% stocks and 50% bonds is tricky! The chart below shows how widely a portfolio’s value can vary depending on your start date. The model portfolio is 50% broad US stocks and 50% US bonds. Here’s what $1,000,000 starting in 1929 vs. 1961 vs. 1975 would have performed with a 4% withdrawal rate and 3% annual inflation:

In Exhibit 3, we can see the vast difference a starting year can make, comparing the portfolio values over time of a portfolio where we assume a 4% withdrawal rate and 3% annual inflation but begin in three very different periods. In the worst case, retirement begins in 1929, on the eve of the Great Depression; in 1961, retirement begins in an “average” period with moderate market returns; and in 1975, we have a 30-year period of exceptionally good returns overall, fueled by falling interest rates and by missing the 2008-2009 Global Financial Crisis.

These may be extremes, but they are extremes that happened to real people and could certain happen again.

A difference of 1% withdrawal rate can be huge over a 30 year retirement. Here’s the difference between a 3% initial withdrawal rate (then adjusted upwards with inflation) and a 4% initial withdrawal rate (then adjusted upwards with inflation) during a period that contained high inflation (1965-1995). Starting out at withdrawing $30,000 a year on a $1,000,000 portfolio would have been just fine, but withdrawing $40,000 a year would have been disastrous.

To examine what a “worst case scenario” regarding inflation might look like, we examine one of the highest inflation periods in modern US history – a retirement starting in 1966 and ending in 1995, which experienced multiple years of double-digit inflation in the mid- to late-1970s. Even a 4% initial withdrawal rate isn’t sustainable given the rapid increase in inflation (the portfolio is expected to meet an annual withdrawal of nearly $200,000 by the end of the 30-year period), exhausting the portfolio in roughly 25 years.

Here’s the 1965-1995 period highlighted from the historical inflation chart. I noticed that the inflation wasn’t sky-high the entire time, but it was elevated over a long-enough period.

The main takeaway from the paper was that the 4% rule does work most of the time, but watch out for periods of high inflation. Don’t blindly take out 4% a year when inflation is high and your portfolio performance is low. The 4% rule may be something like 95% effective historically, but being flexible with your withdrawals will prevent complete disaster even if you are in the bad luck 5%.

Advisor Perspectives has a nice chart of 150 years of historical inflation (1872-2022). I appreciate that it includes both the short-term monthly inflation numbers as well as the 10-year rolling average over this long period of time.

A few basic observations:

• From a long-term perspective, there have been many large sharp spikes in inflation throughout the entire period. Inflation has been a persistently recurring concern.
• From roughly 1872-1940, there were extreme swings between both high inflation and high deflation. Of course, this was also when the dollar was (mostly) on the gold standard.
• From roughly 1950 onward, the rolling 10-year average for inflation has still varied from ~2% to ~9% annually. Given our current low 10-year average, inflation could continue to be elevated for many years and not look out of place on this chart.

My primary takeaway is to always stay mindful of long-term inflation risk. I don’t know what inflation will be next month or next year, but I am confident that it’s coming sooner or later. Some applications (my opinion):

• The 30-year fixed rate mortgage continues to be a great inflation hedge. (Even at high interest rates, that might soon result in lower prices.) As long as you lock in a monthly payment that you can comfortably afford and plan to stay a while, your monthly mortgage payment will only effectively get cheaper over time as inflation eats away at it. If rates drop, you can refinance. If rates rise, you can keep it forever and even rent the property out if you move, as high rates means inflation likely boosted rents while your mortgage payment stayed the same.
• On the flip side, according to Macrotrends, the a 30-year Treasury bond yielded only 1% a year back in 2020. Long-term nominal bonds became a popular portfolio diversifier while rates were dropping (performance chasing), but in reality they became a ticking inflation bomb. I’m still avoiding long-term nominal bonds today.
• A lifetime annuity has definite upsides, but inflation will eat away at the spending power over what could be 30 years. Maybe you’ll get older and spend less each year anyway, but I’d still maintain other assets (like stocks) to hedge that inflation risk. I like single premium immediate annuities as a possible tool for retirement income, but not as the only or primary tool.
• TIPS are complex yet intriguing. I’m still not sure what the best play is right now, but I am happy to keep holding them as part of my bond portfolio. I’m leaning towards moving away from ETFs and more towards a ladder of individual bonds, especially if the real rates on long-term TIPS go any higher.

Retirement income planning would be so much easier if you could buy a known amount of guaranteed lifetime income that automatically adjusted for inflation. However, the reality is that not a single insurance company in the entire world is willing to take on that long-term inflation risk. The only possibility left is to ladder inflation-linked bonds (TIPS) so that each year you would cash out some bonds and interest to create your own DIY inflation-adjusted income.

Thanks to the rising real yields of TIPS, you can now create a 30-year TIPS ladder that will create effectively a 4% guaranteed real withdrawal rate. If you put $1,000,000 into a 30-year TIPS ladder right now, you will get $40,000+ income for year 1 and then another $40,000 adjusted for inflation (CPI-U) annually for the next 29 years. All backed by the US government.

Allan Roth did the hark work and bought a 30-year TIPS ladder x 4.3% real withdrawal rate using $100,000 of his own money on the secondary market. He also introduced me to eyebonds.info, which has a lot of helpful spreadsheets for the hardcore DIY TIPS and Savings I bond investor.

Such a TIPS ladder will only go for 30 years, and you end up with nothing at the end, so it does have some limitations. If you retire at 65 and spend your 4% every year, this portfolio will be completely depleted by age 95. If you start at 55, it will end at 85. Therefore, this tool would work best as a supplement to your Social Security benefits and perhaps keeping some stocks for potential upside…

Now, Allan Roth also wrote about the “No Risk” portfolio where you put most of your money in zero coupon bonds that will guarantee you don’t lose any dollars but put the rest in stocks for upside potential. It feels good to know you’ll both start and end with at least, say $100,000. However, the reality is that you are still exposed to inflation risk, as $100,000 in 10 years may be worth a lot less than $100,000 today.

What if you simply replaced those traditional-style bonds with TIPS as your super-safe base? You’d remove the inflation risk while still keeping minimal credit risk. Enter the concept of Upside Investing by Lawrence Kotlikoff (author of Money Magic).

Upside Investing, as I described in recent Forbes and Seeking Alpha columns, is simple as pie.

– You invest in the S&P and TIPS/I-Bonds and specify a period during which you’ll convert your stocks to TIPS/I-Bonds.

– You build a base living standard floor assuming all stock investments are lost.

– You increase your living standard floor only when and if you convert stocks to TIPS/I-Bonds.

If you can lock in your TIPS ladder at a decent real yield, you could have an intriguing combination of a very safe base income, while still giving you a very good chance of a higher income with stock returns anywhere close to historical averages.

In rough terms, what if a 75% TIPS/25% stock portfolio offered a minimal guaranteed withdrawal rate of 3% real for 30 years (only this low if stocks go to zero!) with the good probability that you would likely be able to withdrawal 4% and quite possibly more. For a conservative investor, knowing you have a rock-solid safe floor would allow you to spend freely with the rest. 🥳 Something to investigate further while TIPS real yields are decent again.

Everyday investors now have trillions of dollars invested inside Target Date Funds (TDFs) with their “set-and-forget” simplicity that provides “industry-standard” investment advice for a relatively low cost. Many people are out there selling better solutions, but I think TDFs are a good default that lets you focus on the saving. Another benefit of TDFs is their structure tends to encourage inaction – There was relatively little TDF selling activity during the March 2020 temporary market drop.

The Callan article Target Date Funds and the Ever-Evolving Glidepath reminds us that “industry standard” investment advice is not written in stone. It’s set by big institutions with marketing departments and does change over time. You are handing over the reigns to the fund provider, be it Fidelity, Vanguard, T. Rowe Price, Blackrock, etc.

Here are the overall trends to TDF asset allocation from in the decade from 2012 to 2022:

• Growth assets (stocks, REITs, junk bonds) went up across the board. Ex. At age 25, growth asset allocation grew from 89% in 2012 to 94% in 2022.
• Fixed income (bonds) have gotten slightly riskier credit ratings at younger ages (presumably to boost yield a bit).
• Inflation-sensitive assets (TIPs, commodities) went down across the board in 2021/2022 than in 2012, only to tick up slightly looking forward in 2022.

What I see are big institutions making small, gradual changes to the glidepath, with the directions almost certainly to be towards mild performance chasing. Nobody gets fired from the executive suite for doing that. From 2012-2022, the stock market has done quite well (more of that!), bond yields have been tiny (let’s crank up the risk to boost yield!), and inflation was very mild (less of that, we don’t need to worry about infla-whoops!). If the next decade has low stock returns, high bond interest rates, and lots of inflation, I would expect a reactionary-but-slow turning of the enormous cruise ship.